The question of whether, or alternatively how, stablecoins should be regulated is getting a lot of attention at the moment. My bias (and yes maybe I am just too institutionalised after four decades in banking) is that regulation is probably desirable for anything that functions as a form of money. We can also observe that some stablecoin issuers seem to be engaging pro actively with the question of how best to do this. There is of course a much wider debate about the regulation of digital assets but this post will confine itself to the questions associated with the rise of a new generation of money like digital instruments which are collectively referred to as stablecoins.
My last post linked to a useful summary that Bennett Tomlin published laying out what is currently playing out in the USA on the stablecoin regulation front. Tomlin concluded that the future of stablecoins appeared to lie in some form of bank like regulation. J.P. Koning has also collated a nice summary of the range of regulatory strategies adopted by stablecoin issuers to date.
Dan Awrey proposes another model for stablecoin regulation
Against that background, a paper titled “Bad Money” by Dan Awrey (Law Professor at Cornell Law School) offers another perspective. One of the chief virtues of his paper (refer Section III.B) is that it offers a comprehensive overview of the existing state regulatory framework that governs the operation of many of the stablecoins operating as “Money Service Businesses” (MSB). The way forward is up for debate but I think that Awrey offers a convincing case for why the state based regulatory model is not part of the solution.
This survey of state MSB laws paints a bleak picture. MSBs do not benefit from the robust prudential regulation, deposit guarantee schemes, lender of last resort facilities, or special resolution regimes enjoyed by conventional deposit-taking banks. Nor are they subject to the same type of tight investment restrictions or favorable regulatory or accounting treatment as MMFs. Most importantly, the regulatory frameworks to which these institutions actually are subject are extremely heterogeneous and often fail to provide customers with a fundamentally credible promise to hold, transfer, or return customer funds on demand.Awrey, Dan, Bad Money (February 5, 202o). 106.1 Cornell Law Review 1 (2020); Cornell Legal Studies Research Paper No 20-38
Awrey also rejects the banking regulation model …
… PayPal, Libra, and the new breed of aspiring monetary institutions simply do not look like banks. MSBs are essentially financial intermediaries: aggregating funds from their customers and then using these funds to make investments. They do not “create” money in the same way that banks do when they extend loans to their customers; nor is there compelling evidence to suggest that their portfolios are concentrated in the type of longer term, risky, and illiquid loans that have historically been the staple of conventional deposit-taking banks
… and looks to Money Market Funds (MMFs) as the right starting point for a MSB regulatory framework that could encompass stablecoins
So what existing financial institutions, if any, do these new monetary institutions actually resemble? The answer is MMFs. While MSBs technically do not qualify as MMFs, they nevertheless share a number of important institutional and functional similarities. As a preliminary matter, both MSBs and MMFs issue monetary liabilities: accepting funds from customers in exchange for a contractual promise to return these funds at a fixed value on demand. Both MSBs and MMFs then use the proceeds raised through the issuance of these monetary liabilities to invest in a range of financial instruments. This combination of monetary and intermediation functions exposes MSBs and MMFs to the same fundamental risk: that any material decrease in the market value of their investment portfolios will expose them to potential liquidity problems, that these liquidity problems will escalate into more fundamental bank-ruptcy problems, and that—faced with bankruptcy—they will be unable to honor their contractual commitments. Finally, in terms of mitigating this risk, neither MSBs nor MMFs have ex ante access to the lender of last resort facilities, deposit guarantee schemes, or special resolution regimes available to conventional deposit-taking banks.
In theory, therefore, the regulatory framework that currently governs MMFs might provide us with some useful insights into how better regulation can transform the monetary liabilities of MSBs into good money.
Awrey’s preferred model is to restructure the OCC to create three distinct categories of financial institution …
The first category would remain conventional deposit-taking banks. The second category—let’s call them monetary institutions—would include firms such as PayPal that issued monetary liabilities but did not otherwise “create” money and were prohibited from investing in longer-term, risky, or illiquid loans or other financial instruments. Conversely, the third category—lending institutions—would be permitted to make loans and invest in risky financial instruments but expressly prohibited from financing these investments through the issuance of monetary liabilities
Stablecoins would fall under the second category (Monetary Institutions) in his proposed tripartite licensing regime and the regulations to be applied to them would be based on the regulatory model currently applied to Money Market Funds (MMF).
What does Awrey’s paper contribute to the stablecoin regulation debate?
- Awrey frames the case for stablecoin regulation around the experience of the Free Banking Era
- This is not new in itself (see Gorton for example) but, rather than framing this as a lawless Wild West which is the conventional narrative, Awrey highlights the fact that these so called “free banks” were in fact subject to State government regulations
- The problem with the Free Banking model, in his analysis, is that differences in the State based regulations created differences in the credit worthiness of the bank notes issued under the different approaches which impacted the value of the notes (this is not the only factor but it is the most relevant one for the purposes of the lessons to be applied to stablecoin regulation)
Finally, the value of bank notes depended on the strength of the regulatory frameworks that governed note issuing banks. Notes issued by banks in New York, or that were members of the Suffolk Banking system, for example, tended to change hands closer to face value than those of banks located in states where the regulatory regimes offered noteholders lower levels of protection against issuer default. Even amongst free banking states, the value of bank notes could differ on the basis of subtle but important differences between the relevant requirements to post government bonds as security against the issuance of notes bank notes.
- If we want stablecoins to reliably exchange at par value to their underlying fiat currency then he argues we need a national system of regulation applying robust and consistent requirements to all issuers of stablecoin arrangements
- Awrey then discusses the ways in which regulation currently “enhances the credibility of the monetary liabilities issued by banks and MMFs to set up a discussion of how the credibility of the monetary promises of the new breed of monetary institutions might similarly be enhanced
- He proposes that the OCC be made accountable for regulating these “monetary institutions” (a term that includes other payment service providers like PayPal) but that the regulations be based on those applied to MMFs other than simply bringing them under the OCC’s existing banking regulations
- The paper is long (90 pages including appendices) but hopefully the summary above captures the essence of it – for me the key takeaways were to:
- Firstly to understand the problems with the existing state based MSB regulations that currently seem to be the default regulatory arrangement for a US based stablecoin issuer
- Secondly the issues he raises (legitimate I think) with pursuing the bank regulation based model that some issuers have turned to
- Finally, the idea that a MMF based regulatory model is another approach we should be considering
I will wrap up with Awrey’s conclusion …
Money is, always and everywhere, a legal phenomenon. This is not to suggest that money is only a legal phenomenon. Yet it is impossible to deny that the law plays a myriad of important and often poorly understood roles that either enhance or undercut the credibility of the promises that we call money. In the case of banks and MMFs, the law goes to great lengths to transform their monetary liabilities into good money. In the case of proprietary P2P payment platforms, stablecoin issuers, and other aspiring monetary institutions, the anti-quated, fragmented, and heterogenous regulatory frameworks that currently, or might in future, govern them do far, far less to support the credibility of their commitments. This state of affairs—with good money increasingly circulating alongside bad—poses significant dangers for the customers of these new monetary institutions. In time, it may also undermine the in-tegrity and stability of the wider financial system. Together, these dangers provide a compelling rationale for adopting a new approach to the regulation of private money: one that strengthens and harmonizes the regulatory frameworks governing monetary institutions and supports the development of a more level competitive playing field.
Tony – From the Outside